Value Investing Is My Life

"Value investing is easy it is sick. Everyday, I read to expand my circle of competence. That's all."

"When I read , I know. When I study, I remember. When I do, I understand. When I went to Buffett's meetings, I self-actualized."

"My risk management control is to reject investment ideas."

-- Mike Onghai

Wednesday, November 30, 2005

My 2 cents on all this Naked Short Selling Stuff

After reading all I can find about this naked short selling stuff, I can't help but conclude that Patrick Byrne is really on to something. Anybody with an IQ above 120 should come to the same conclusion, if they read what is out there.

I have obtained permission from Patrick Byrne, CEO of Overstock.com to post the following posts he made on a popular investing web site. Read the two posts and see for yourself

Post #1

Here is something odd for those following this story:

Back on August 8th I bought some 25,000 shares (I think the filing ended up showing 50,000 shares because I bought the rest that day or the day before). Oddly, I could not get delivery of them for weeks and weeks. I am not talking about, "paper certificates". I am talking about simply seeing the trade clear. All along, my broker was saying that Morgan Stanley could not deliver on their side of the transaction.

I will now relay an email between myself and my Broker Dealer (whom I will call, "BD") that occurred when it finally cleared, after weeks of unhappy phone calls.===============================================================September 299:11 AMGood Morning Patrick:

The 25,000 shares of OSTK originally transacted for on August 8th, came in during the night and we have initiated the process of converting to paper. Settlement is taking place today.

I would like to hear from you or someone on your trading desk what exactly is the meaning of, "The 25,000 shares of OSTK originally transacted for on August 8th, came in during the night".

What does "come in" mean (since they clearly are not mailed pieces of paper)?

How did they manage to keep from "coming in" for 50 days?

From whom did they come in?

Respectfully,Patrick

=============================================================

2:15 PMPatrick:

To the best of my knowledge it means that the incoming shares appear in the electronic system (SEI) which displays the stock trade transactions via PC, and this evidently takes place , like bank processing, as an overnight transaction. The August 8th date is the date I have recorded in my notes as the date of your second purchase of shares of OSTK, the date ZZZZZZZ entered into the transaction with Morgan Stanley to purchase the 25,000 shares.

I am going to ask some of our professionals from the trade area to respond, and hopefully give you a better explanation of how the shares move to BD from another brokerage house.

As to the 50 days the shares did not come in, the only answer we have obtained from the Morgan Stanley people when we repeatedly pressured them is this: "you have to understand that this is an extremely hot stock". Obviously not an answer that makes any sense; but an answer that was repeated time and time again as we made calls to the management at Morgan Stanley.

I will forward additional information to you as soon as I am able to obtain it from the BDBDBD group.

Now Fools, I don't know about you, but I find this pretty weird. Let them post more photos of me with UFO's flying out of my head, but something seems messed up in a system that allows this.

(By the way, Morgan Stanley lawyers, when you read this you are going to get ticked off and want to fire off a letter threatening to sue me. Better check with your stock loan desk first to see if you want discovery. Go ahead: make my day.)

Here is the punch line: my Pop bought 200,000 shares right at the end of August. He still has not gotten delivery. Again, I am not speaking of certs. I speak simply of the settlement of the trade. His broker is saying that the other brokerage house is unable to settle the transaction.

Any guesses as to who that brokerage house is? I'll give you three guesses. It is one of the big ones.

Does this strike anyone else here as odd? I mean, I can understand the fellow Tiddman who was writing, more or less, "Byrne, just focus on the business." Ironically, I am entirely from the value school and agree that in almost any circumstance one should just focus on the business. But given that simple stock purchases seem to be cracking the system, and given that I believe we have somewhere between 5 and 20 million electronically counterfeited shares in the market, and given that I suspect there is some relation between these two facts, and given that I think this situation may well be endemic in the market, I think at some point I am supposed to do something about it. Well, someone is, anyway. I could be wrong, though: when it takes 50 days to get 25,000 shares of stock to clear, Lord knows I'm not in Kansas anymore.

Respect,

Patrick

Post #2

Heart of the Matter,

Nice work. You have exactly the right feel for what is going on. These guys will always ask for "proof" and then deride whatever is submitted (even before they get a chance to review it: see how the 5 or 6 lapdog journalists in New York blared against our affiants before they ever read the affidavits). But the truth is, when it comes to Refco, or the more general harm that naked shorting is doing to the markets, I don't feel we have proof: all we have is a lot of data that, taken collectively, create a foreboding picture. The only people who have the complete are the SEC picture (though there is even doubt about that). However, the SEC's refusal to be forthcoming on the facts, and their stiff-arming every attempt to acquire proof one way or another, does not fill me with confidence that, were all the facts known, we would rest easy at night.

Take Refco (please). It is absolutely true that we don't have proof that the $431 million liability buried underneath Refco is a barrel of naked shorts. All we know is that the Sedona case was one of the only times the SEC stepped in on the side of the company being abusively sorted, so one could assume the abuse was particularly egregious; we know that Refco's name was all over the case for accepting instructions to short Sedona mercilessly clearing from Rhino Advisors, whose trades they cleared. We know Sedona was naked shorted (estimate: 50 million to 200 million shares); we know that Rhino Advisors saw criminal charges then blew up; we know that the SEC investigation of Refco centered on Bennett and Santo Maggio; we know Maggio's duties included the stock lending desk; and we know the SEC spent a couple years “negotiating" a suitable penalty with the Refco. We know that Michael Garcia, the US Attorney for the Southern District of New York, said that the liability was marked-to-market every day but that he would not disclose what it was. We can watch the subsequent trading in Sedona and see that a certain European bank crosses the market every day, offering stock below the bid so that the stock can never trade up (though this be illegal), almost as though someone fears a squeeze. And we know that all parties have bent over backwards to prevent the details of the $431 million liability from leaking.

Together, all these facts lead some people suspect that there is a barrel of toxic waste underneath Refco marked, "naked shorts: SDNA". Party hacks demand, "Where's the proof?" in an attempt to distract you from the simple truth that the facts are knowable in this case, someone knows them, and those people are doing everything in their power to prevent the facts from becoming known to the public.

For the newbies: why is this so significant? Sedona has about 87 million shares of common stock issued. Pretend for a moment that there really are 100 million naked shorts, buried underneath Refco. Since it trades at 14 cents right now, Refco might be carrying that as a $14 million contingent liability. Suppose they try to clean it up someday. They take $14 million into the market and try to buy 100 million shares. The stock currently trades about 50,000 shares/day. Buying all the volume, it would take 2,000 trading days to cover their short. More realistically, the stock would squeeze and its price would rise, and buying those 100 million shares would take not $14 million, but …. Who knows? $140 million. $500 million? By extension, if a significant amount of the $431 million is made up of these types of liabilities, "marked-to-market" but not "marked-to-where-the-market-would-be-if-Refco-actually-had-to-deliver," the process of actually settling these trades, or the >$6 billion like them apparently scattered throughout the system, could be greater than the liquidity in that system.

Are we right about the possibility that the overhang of naked shorting has destroyed companies and represents a serious threat to the stability of the market, and that the SEC has its thumb on the scale in favor of hedge funds and against entrepreneurs? Again, the answer is knowable, someone does know it, and that someone is sitting somewhere in the SEC. But getting the data out of the SEC that would confirm one way or another is difficult (thus allowing the same guys to parrot the party line over and over: "You see, you don't have any proof!")

Yet what the party line hacks miss is that what we don't know is nearly as instructive as what we know. Let me give you some examples, starting with Overstock's case and then going more broadly. In each of these points I will try to be clear about what I know and what I don't know, and ask the reader to keep in mind this question: does the boundary of Byrne's knowledge make one more or less confident that this is a problem that can safely be ignored?

1) Given that we are on the Reg SHO Threshold list, and have been since January 27 (with, as I recall, a couple weeks absence in March-April), I know that there are FTD's (naked shorts) in OSTK.

2) OK, so we are on the Reg SHO Threshold list. How many naked shorts are there?

Well, I know that our threshold was set to be .5% of our shares outstanding (which is close to 20 million, so call this 100,000) + however many unsettled naked shorts existed on Jan 3, 2005. How many was that? The SEC and NASSDAQ, do not say (refuse to, actually). All I know about it is that it is some number.

And how far over the threshold are we? Again, the SEC and NASDAQ will not disclose this, so again, all I can say for sure is that it is some other number.

So thanks to the SEC's heroic efforts to crack down on this practice by passing Reg SHO, I now know that OSTK's level of FTD's equals some number that is over our threshold by some number, and that this threshold is itself equal to 100,000 plus some other number. Great.

Got that? And yet the party line guys want to say that my lack of knowledge on the subject of how many naked shorts there are in the system, precisely, should count as a point against me. To which I respond, at some point, doesn't this nonsense count as a point against the system? If it was a de minimus amount, would it be this hard to find out that amount?

3) Overstock is not, of course, alone on the Reg SHO list. There are a couple hundred companies in the same situation. In June, a Freedom of Information Act request revealed that by day, every day on NYSE and NASDAQ, 100 million - 250 million shares fail to settle (about 5%). This has permitted some decent people to perform the following analysis (some strangers did it, and got in touch with me to tell me this: I have not checked their work closely but it seems pretty solid on its face). They measured how much the FTD's moved every day, backed out of this number the trading in the very lightly traded stocks on the Reg SHO list, and came to the conclusion that 125-130 million or so of FTD's were concentrated in about 30-35 stocks. That comes to about 4 million FTD's per company. Earlier in this message I walked through the math on what might happen if folks were required to deliver on all their FTD's in Sedona. If you want to know what might happen if they were forced to deliver on all outstanding FTD's of all these companies, you could probably take the Sedona calculation, and square it.

4) Anyone who follows this so far can see that it establishes prima facie grounds for suspecting this might be a pretty deep problem. I, for one, think that it points in the direction of the proper understanding of the construction of Reg SHO, in particular, its grandfathering of past FTD's and its apparent bias towards the hedge funds engaged in naked shorting. The explanation is simply that the problem is so deep that the SEC fears that the system might implode if they actually forced these FTD's to settle, and that they are temperamentally inclined to favor the interests of Wall Street over the interests of Main Street anyway. But still, the party line guys will say, “But where is the proof?! Where is the proof?!?!?” They seem to forget that evidence plus reason is a kind of proof, especially in the absence of countervailing arguments, as we are experiencing today. However, if they insist on proof that this is not all some madman's fantasy, I suggest they turn to the FAQ's of the sec.gov website itself, and a discussion to be found there on Reg SHO.

Why did the SEC grandfather all failures-to-deliver up to January 3, 2005? In the SEC's words (IV F):

“The requirement to close-out fail to deliver positions in threshold securities that remain for 13 consecutive settlement days does not apply to positions that were established prior to the security becoming a threshold security. This is known as 'grandfathering.' For example, open fail positions in securities that existed prior to the effective date of Regulation SHO on January 3, 2005 are not required to be closed out under Regulation SHO.

“The grandfathering provisions of Regulation SHO were adopted because the Commission was concerned about creating volatility where there were large pre-existing open positions.”

OK, check. I believe that the system might implode if they forced these trades to settle. The SEC's own words are that they grandfathered the level of failures on January 3, 2005 because they were “concerned about creating volatility where there were large pre-existing open positions.” I believe that is the “evidence” these guys are demanding, HeartoftheMatter.

Where is the evidence that they have their thumb on the scale in the favor of hedge funds? Again, they are pretty explicit about it in the same FAQ (V 11):

“The fails statistics of individual firms and customers is proprietary information and may reflect firms' trading strategies. The release of this information could be used to engage in unlawful upward manipulation of the price of the securities in order to 'squeeze' the firms improperly.”

Again: check. As far as the SEC is concerned, the decision by some to naked short is simply a “trading strategy,” and it is not the SEC's place to reveal a firm's proprietary trading strategy.

The thing is, there is a technical term for trading strategies that rely on selling something that you don't own, don't borrow, and don't deliver. That term is, “illegal.” It is “illegal” to collect money for selling something that you own, borrow, or deliver. Selling the Brooklyn Bridge when you don't really own it, for example, would be, “illegal.” And because some hedge funds have made doing something that is “illegal” the core of their “trading strategies,” the SEC is refusing to reveal the size of the hole that those funds have dug in any particular stock because that might reveal something about their illegal trading strategies, because that would be “improper.” They even give an example of one way it might be improper: in the case of stocks that had seen this kind of heavy manipulation downwards, releasing the size of the naked shorts would let some people see how the stock had been artificially watered down, which would perhaps lead some to buy the stock believing that there was an artificial misprice, and this would create a situation where the stock…. went up. In the eyes of the SEC this would be “improper”: after all, we know that hedge funds who use illegal trading strategies to generate high levels of naked shorts can count on not even the size of those naked short positions being disclosed, because that might allow others to reverse engineer their proprietary illegal trading strategies. And it might even make some to recognize that a stock had been manipulated downwards, leading them to buy it at what they would perceive as an artificially low price, thus creating the risk that stock would go up. Which is, as we all know, improper. How could it be proper? The hedge funds' illegal trading strategy demands that the stocks go down: how could the SEC possibly allow a situation where they go up?

Everyone got that?

Can anyone say, “captured regulator”?

I knew before I launched that I would be going down a few rabbit-holes, and that some would call me a nut-job for doing so. But can anyone read this Alice-in-Wonderland stuff from the SEC and not begin to wonder which way is up? I know I am coloring outside the lines at times (going on TV and calling the SEC “captured regulators” is not a strategy often recommended by securities lawyers as one designed to curry favor, for example). But as far as I can tell, there are no lines for the bad guys, at least as far as the SEC is concerned: forcing the bad guys to respect lines would create “volatility,” and revealing the degree by which they were ignoring the lines would reveal their proprietary illegal trading strategies, and might even let the stocks they were shorting go up, which would be “improper,” naturally.And they call me “nuts.”

So, take heart, Heartofthematter: these guys keep asking for proof, but at this point I am not sure what they really mean. It is out in the open: in the SEC website, in a FOIA response, in the footnotes to the Refco story, in the daily Reg SHO list itself. Our opponents will always pretend not to see how these all add up, and instead blindly parrot a party line that is getting more hackneyed with each passing week.

To the unthinking repetition of their mantra, “where's the proof?” you should simply rejoin, “Settle the trades.”

Here's a good story of manipulation ...

About Me

My investing philosophy is an amalgamation of my five great inspirations and direct teachers: Graham&Dodd, Buffett and Munger's Latticework of Mental Models, Phil Fisher, and of course, my two direct teachers, Marty Whitman, and Joel Greenblatt.
Numerous studies (See Fama-French, Lakonishok, Piotroski) have been made confirming that a value strategy beats a growth strategy in U.S. and international markets. I look for investment ideas that fall into 4 baskets: excellent businesses( high returns on capital, that can deploy retained earnings and yield higher than the cost of capital) at fair prices, stocks selling for below liquidation values (the cigar butts), stocks selling for below net ascertainable values (Marty Whitman), and special situations (Joel Greenblatt -- spinoffs, post-bankruptcies, and liquidations).
I have a degree in Computer Science and Engineering and I am a member of the ValueInvestorsClub.com .
I help run a fund using these principles here in the U.S. Beginning in 2006, I will also run a fund with a satellite office in Asia. The focus will be investing in companies that will enjoy benefits of the growth opportunities in Asia.